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UPSC MainsMANAGEMENT-PAPER-I201810 Marks
Q26.

Calculate the weighted average cost of capital for Atul Mahindra Ltd.

How to Approach

This question requires a practical application of financial management principles. The approach involves understanding the WACC formula, identifying the components of capital (equity, debt), calculating the cost of each component, and then weighting them based on their proportion in the capital structure. The answer should clearly state the assumptions made due to the lack of specific data for Atul Mahindra Ltd. and demonstrate the calculation process step-by-step. A tabular representation of the calculations will enhance clarity.

Model Answer

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Introduction

The Weighted Average Cost of Capital (WACC) is a crucial financial metric representing a company’s average after-tax cost of all its capital. It reflects the minimum rate of return a company needs to earn on its existing asset base to satisfy its investors, including stockholders and lenders. WACC is widely used in investment decisions, capital budgeting, and company valuation. Calculating WACC requires determining the cost of equity, cost of debt, and the proportion of each in the company’s capital structure. Since specific financial data for Atul Mahindra Ltd. is not provided, we will make reasonable assumptions for illustrative purposes.

Understanding the WACC Formula

The WACC is calculated using the following formula:

WACC = (E/V * Re) + (D/V * Rd * (1 – Tc))

Where:

  • E = Market value of equity
  • D = Market value of debt
  • V = Total market value of capital (E + D)
  • Re = Cost of equity
  • Rd = Cost of debt
  • Tc = Corporate tax rate

Assumptions for Atul Mahindra Ltd.

Due to the lack of specific data, we will make the following assumptions (as of knowledge cutoff – 2023):

  • Market Value of Equity (E): ₹5000 Crore
  • Market Value of Debt (D): ₹2000 Crore
  • Total Capital (V): ₹7000 Crore (E + D)
  • Cost of Equity (Re): 12% (estimated based on industry average and CAPM)
  • Cost of Debt (Rd): 8% (based on prevailing interest rates for similar companies)
  • Corporate Tax Rate (Tc): 25% (standard corporate tax rate in India)

Calculating the Cost of Equity (Re)

While we've assumed Re = 12%, it's typically calculated using the Capital Asset Pricing Model (CAPM):

Re = Rf + β(Rm – Rf)

Where:

  • Rf = Risk-free rate (e.g., Government bond yield)
  • β = Beta (measure of systematic risk)
  • Rm = Expected market return

For our example, we are directly using the assumed value of 12%.

Calculating the Cost of Debt (Rd)

The cost of debt is the effective interest rate a company pays on its debt. We have assumed a cost of debt of 8%.

Calculating the WACC

Now, we can plug the values into the WACC formula:

WACC = (5000/7000 * 0.12) + (2000/7000 * 0.08 * (1 – 0.25))

WACC = (0.7143 * 0.12) + (0.2857 * 0.08 * 0.75)

WACC = 0.0857 + 0.0171

WACC = 0.1028 or 10.28%

Sensitivity Analysis

It’s important to note that WACC is sensitive to changes in its components. A change in the cost of equity, cost of debt, or capital structure will affect the WACC. For example, if the cost of equity increases to 13%, the WACC would increase to approximately 10.86%.

Component Value (₹ Crore) Proportion (%) Cost (%) Weighted Cost (%)
Equity 5000 71.43 12 8.57
Debt 2000 28.57 8 1.71
Total 7000 100 10.28

Conclusion

In conclusion, the weighted average cost of capital for Atul Mahindra Ltd., based on the assumed values, is approximately 10.28%. This represents the minimum return the company needs to earn on its investments to satisfy its investors. It’s crucial to remember that this is an illustrative calculation based on assumptions. A precise WACC calculation requires accurate and up-to-date financial data. Regularly monitoring and recalculating WACC is essential for effective financial management and investment decision-making.

Answer Length

This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.

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Additional Resources

Key Definitions

Capital Structure
The proportion of debt and equity a company uses to finance its assets. It impacts the company’s risk and return profile.
Capital Asset Pricing Model (CAPM)
A model used to determine the theoretically appropriate required rate of return of an asset, or the cost of equity, given the risk-free rate, the asset's beta, and the expected market risk premium.

Key Statistics

India's corporate tax rate was reduced from 30% to 25% for companies with a turnover of up to ₹400 crore in the financial year 2019-20.

Source: Press Information Bureau, Government of India (2019)

The average cost of debt for Indian companies in the manufacturing sector was around 7.5-9.5% in 2023.

Source: RBI data, various financial reports (knowledge cutoff 2023)

Examples

Reliance Industries WACC

Reliance Industries, a large Indian conglomerate, consistently monitors its WACC to evaluate investment opportunities and optimize its capital structure. Their WACC fluctuates based on market conditions and their debt-equity mix.

Frequently Asked Questions

▶What is the impact of a higher debt-to-equity ratio on WACC?

A higher debt-to-equity ratio generally lowers WACC, as debt is usually cheaper than equity (due to the tax shield). However, it also increases financial risk, potentially leading to higher costs of both debt and equity in the long run.

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